1. Types of Mutual Funds that Use Derivatives:
- Index funds: Frequently use derivatives, such as options and futures, to manage cash balances, liquidity, and transaction costs.
- Other mutual funds: Some actively managed funds use derivatives for hedging or investment purposes, as long as the fund’s prospectus allows it.
2. Regulations Governing Derivatives Use:
- National Instrument (NI) 81-102: The primary regulation governing mutual funds in Canada, outlines how mutual funds can use derivatives, emphasizing risk reduction and limiting speculative activities.
- Specific guidelines under NI 81-102: These allow derivatives for both hedging and non-hedging purposes, while setting restrictions on counterparties' credit ratings and overall exposure to derivatives.
3. Necessary Disclosures:
- A fund's prospectus must disclose its use of derivatives, specifying how they will be used to achieve investment objectives, the risks involved, and any applicable limits.
4. Hedging vs. Non-Hedging Purposes:
- Hedging: Derivatives are used to offset specific risks (e.g., currency or interest rate risks) with instruments like futures or options that move inversely to the fund's position.
- Non-Hedging: Derivatives can be used to gain market exposure or enhance income without owning the underlying assets. For instance, index derivatives allow exposure to an entire market without buying the individual securities.
5. How Mutual Funds Use Derivatives:
- For hedging: Primarily to manage risks such as foreign currency exposure or interest rate risk.
- For non-hedging: To create market exposure or enhance income, often through the sale of options or the purchase of futures.
6. Advantages and Disadvantages of Using Derivatives:
Advantages:
- Risk reduction: Especially with currency hedging.
- Ease of execution: Allows quick access to broad market exposure.
- Lower costs: Especially for international markets, derivatives can reduce transaction and administrative costs.
- Greater asset selection: Provides access to markets that may otherwise be difficult to enter.
- Portfolio income: Selling options can generate income.
Disadvantages:
- Income considerations: Derivatives may not offer dividends or interest that would come from directly holding the underlying assets.
- Expiration dates: Derivatives contracts must be rolled over at expiration, adding administrative complexity.
- Limited gains: Hedging may limit potential upside.
- Transparency: Some investors may find it difficult to fully understand the fund's exposure due to the complexity of derivatives.
- Tax implications: Income from derivatives is often taxed as regular income, not capital gains.
- Costs: Derivatives may involve additional administrative and management expenses.
- Counterparty risk: Exposure to the creditworthiness of derivatives counterparties can pose risks, especially with OTC derivatives.
This chapter provides a thorough examination of the framework for using derivatives in mutual funds, emphasizing the balance between their potential benefits and inherent risks.
You said:
ChatGPT said:
Here are 30 challenging and complex multiple-choice questions based on the content of the chapter regarding the permitted uses of derivatives by mutual funds, along with answers and explanations:
1. Which of the following mutual fund types is most likely to use derivatives for liquidity management?
A. Equity funds
B. Balanced funds
C. Index funds
D. Fixed income funds
Answer: C. Index funds
Explanation: Index funds often use derivatives to manage cash balances and liquidity. Derivatives provide a quick and cost-effective way to access index returns, allowing funds to handle redemptions or new contributions without directly buying or selling the underlying securities.
2. Under NI 81-102, a mutual fund can use derivatives for non-hedging purposes if it meets which of the following requirements?
A. The derivative must have a positive correlation with the fund’s NAV
B. The derivative must increase the leverage of the fund
C. The derivative must reduce transaction costs and provide market exposure
D. The derivative must eliminate all risk associated with the underlying asset
Answer: C. The derivative must reduce transaction costs and provide market exposure
Explanation: Non-hedging derivatives are often used by mutual funds to reduce transaction costs and gain quick market exposure without owning the underlying assets. NI 81-102 places restrictions to prevent excessive speculation but allows derivatives for efficiency purposes.
3. According to NI 81-102, what is the maximum allowable exposure of a mutual fund to a single over-the-counter (OTC) derivatives counterparty?
A. 5% of the fund’s net assets
B. 10% of the fund’s net assets
C. 20% of the fund’s net assets
D. 30% of the fund’s net assets
Answer: B. 10% of the fund’s net assets
Explanation: NI 81-102 sets a limit on the exposure to an individual OTC derivatives counterparty at 10% of the fund’s net assets, in order to mitigate counterparty risk.
4. Which of the following criteria must a derivative meet to qualify as a hedge under NI 81-102?
A. The derivative must offset exactly 100% of the underlying position
B. The derivative must have a high degree of positive correlation with the underlying position
C. The derivative must have a high degree of negative correlation with the underlying position
D. The derivative must enhance the fund’s returns
Answer: C. The derivative must have a high degree of negative correlation with the underlying position
Explanation: For a derivative to qualify as a hedge under NI 81-102, it must have a high degree of negative correlation with the position it is hedging, meaning it moves in the opposite direction, reducing risk.
5. What is the key benefit of using derivatives for asset allocation in a mutual fund?
A. Higher management fees
B. Greater exposure to individual securities
C. Lower transaction and slippage costs
D. Enhanced tax treatment
Answer: C. Lower transaction and slippage costs
Explanation: Derivatives allow mutual fund managers to quickly adjust their portfolio allocations without incurring the high transaction and slippage costs associated with buying or selling individual securities.
6. Which of the following is NOT a permitted derivative under NI 81-102 for hedging purposes?
A. Short call options
B. Long put options
C. Long call options
D. Short forward contracts
Answer: C. Long call options
Explanation: Long call options are typically used to gain exposure rather than hedge an existing position. For hedging purposes, instruments like short call options, long put options, and short forward contracts are typically used to offset or reduce risk.
7. Which of the following statements is true regarding the use of currency cross-hedges in mutual funds under NI 81-102?
A. Currency cross-hedges are used to speculate on currency movements
B. Currency cross-hedges increase the overall currency risk of a portfolio
C. Currency cross-hedges are permitted as long as the NAV currency exposure is not increased
D. Currency cross-hedges eliminate all currency risk
Answer: C. Currency cross-hedges are permitted as long as the NAV currency exposure is not increased
Explanation: NI 81-102 allows currency cross-hedges as long as the total currency risk to the fund is not increased, ensuring that such hedges remain conservative in nature and primarily for risk management.
8. Which of the following would a mutual fund manager likely use to increase the duration of a fixed income portfolio?
A. Sell long-term Treasury bond futures
B. Buy short-term Treasury bill futures
C. Sell short-term Treasury note futures
D. Buy long-term Treasury bond futures
Answer: D. Buy long-term Treasury bond futures
Explanation: Buying long-term Treasury bond futures increases a portfolio's duration by extending the time to maturity of the interest rate exposure. This allows the fund to become more sensitive to changes in interest rates.
9. A mutual fund manager writes a covered call option. What is the fund manager’s obligation if the option is exercised?
A. Buy the underlying asset at the market price
B. Sell the underlying asset at the strike price
C. Buy the underlying asset at the strike price
D. Sell the underlying asset at the market price
Answer: B. Sell the underlying asset at the strike price
Explanation: When writing a covered call option, the fund manager agrees to sell the underlying asset at the strike price if the option is exercised. The manager receives an option premium for taking on this obligation.
10. What is the primary risk for a mutual fund manager writing a cash-secured put option?
A. The price of the underlying security rises
B. The fund must buy the underlying security at a higher market price
C. The underlying security’s price falls below the strike price
D. The option expires worthless
Answer: C. The underlying security’s price falls below the strike price
Explanation: The primary risk in writing a cash-secured put option is that the price of the underlying security falls below the strike price, forcing the manager to buy the security at a higher price than the market.
11. A mutual fund uses interest rate swaps to adjust its exposure to interest rate risk. To decrease the duration of the fund, the manager would most likely:
A. Buy long-term fixed-for-floating swaps
B. Sell short-term floating-for-fixed swaps
C. Sell long-term fixed-for-floating swaps
D. Buy short-term floating-for-fixed swaps
Answer: C. Sell long-term fixed-for-floating swaps
Explanation: Selling long-term fixed-for-floating swaps decreases a portfolio's duration by reducing its exposure to long-term interest rate changes. This makes the fund less sensitive to interest rate movements.
12. Which of the following is a disadvantage of using derivatives in mutual funds for hedging purposes?
A. Derivatives increase the fund’s leverage
B. Derivatives are not allowed under NI 81-102
C. Derivatives do not protect against credit spread risk
D. Derivatives are tax inefficient
Answer: C. Derivatives do not protect against credit spread risk
Explanation: Derivatives used for hedging purposes may not protect against certain risks, such as credit spread risk in the case of corporate bonds. This is a limitation in hedging strategies using instruments like government bond futures.
13. Which of the following best describes execution slippage in the context of derivatives?
A. The inability to execute a derivatives trade at the desired price
B. The risk of not settling a derivatives contract on time
C. The gradual erosion of returns due to transaction costs
D. The difference between the expected and actual returns of a derivatives trade
Answer: A. The inability to execute a derivatives trade at the desired price
Explanation: Execution slippage occurs when a manager cannot execute a derivatives trade at the intended price, often due to market movements that worsen the price after the trade is initiated.
14. Which of the following mutual funds is least likely to benefit from the use of derivatives?
A. A domestic large-cap equity fund
B. A bond fund with long-term corporate bonds
C. An international index fund
D. An emerging markets equity fund
Answer: A. A domestic large-cap equity fund
Explanation: Domestic large-cap equity funds typically have more stable holdings, and their need for derivatives is lower compared to bond funds, international funds, or emerging markets funds, which face higher currency and interest rate risks.
15. Why might a fund manager choose a swap over an exchange-traded derivative to replicate an index return?
A. Swaps are cheaper than exchange-traded derivatives
B. Swaps provide more leverage than exchange-traded derivatives
C. Swaps can be customized to match specific fund requirements
D. Swaps eliminate counterparty risk
Answer: C. Swaps can be customized to match specific fund requirements
Explanation: Swaps are often used to replicate index returns when customization is needed. Unlike exchange-traded derivatives, which are standardized, swaps can be tailored to match a fund's particular needs.
16. A fund manager is concerned about the impact of a rising Canadian dollar on a fund holding significant U.S. assets. What is the most appropriate derivative strategy to hedge this currency risk?
A. Buy Canadian dollar forward contracts
B. Buy U.S. dollar forward contracts
C. Sell Canadian dollar forward contracts
D. Sell U.S. dollar forward contracts
Answer: D. Sell U.S. dollar forward contracts
Explanation: To hedge against the impact of a rising Canadian dollar, the fund manager would sell U.S. dollar forward contracts. This locks in an exchange rate and mitigates the risk of currency loss from U.S. dollar-denominated assets.
17. Which of the following is a key regulatory limitation on the use of derivatives in Canadian mutual funds under NI 81-102?
A. Mutual funds can only use exchange-traded derivatives
B. Mutual funds cannot use derivatives for speculative purposes
C. Mutual funds cannot use derivatives for risk reduction
D. Mutual funds can only use derivatives to increase leverage
Answer: B. Mutual funds cannot use derivatives for speculative purposes
Explanation: NI 81-102 imposes restrictions on mutual funds, preventing them from using derivatives for speculative purposes. The use of derivatives must be aligned with the fund’s investment objectives, primarily focusing on risk management.
18. If a mutual fund manager is using bond futures to adjust portfolio duration, what are they trying to manage?
A. The portfolio’s sensitivity to interest rate changes
B. The portfolio’s exposure to currency risk
C. The portfolio’s exposure to market volatility
D. The portfolio’s leverage ratio
Answer: A. The portfolio’s sensitivity to interest rate changes
Explanation: Duration measures the sensitivity of a bond portfolio to interest rate changes. By using bond futures, a mutual fund manager can either increase or decrease the portfolio’s exposure to interest rate movements.
19. What is the primary advantage of writing covered call options in a mutual fund portfolio?
A. Enhancing portfolio leverage
B. Increasing portfolio income
C. Reducing portfolio risk
D. Decreasing exposure to market downturns
Answer: B. Increasing portfolio income
Explanation: Writing covered call options allows a mutual fund to generate additional income through the premiums received. However, this strategy limits the upside potential if the underlying stock price rises above the strike price.
20. Which of the following derivative instruments is most commonly used by index funds to replicate index performance without purchasing all underlying securities?
A. Currency swaps
B. Bond futures
C. Index futures
D. Interest rate swaps
Answer: C. Index futures
Explanation: Index futures are commonly used by index funds to replicate the performance of an entire index without having to buy each individual security in the index. This allows for more efficient management of the fund’s cash flows.
21. What is a potential disadvantage of using derivatives for non-hedging purposes in a mutual fund?
A. Reduced leverage
B. Increased transparency for investors
C. Greater transaction costs
D. Potential tax inefficiencies
Answer: D. Potential tax inefficiencies
Explanation: Derivatives used for non-hedging purposes, such as earning income, may result in tax inefficiencies, as income from derivatives can be taxed at higher rates than capital gains.
22. In which of the following situations would a mutual fund manager likely use a long put option?
A. To hedge against a decline in the value of a stock held in the portfolio
B. To increase the leverage of the portfolio
C. To generate income from option premiums
D. To gain exposure to a stock that is expected to rise in value
Answer: A. To hedge against a decline in the value of a stock held in the portfolio
Explanation: A long put option is used to hedge against potential declines in the value of a stock, as the option increases in value if the stock price falls.
23. Why might a fund manager prefer OTC derivatives over exchange-traded derivatives for currency hedging?
A. OTC derivatives have lower counterparty risk
B. OTC derivatives are more liquid
C. OTC derivatives allow for more tailored and customized contracts
D. OTC derivatives are always cheaper than exchange-traded derivatives
Answer: C. OTC derivatives allow for more tailored and customized contracts
Explanation: OTC derivatives can be customized to fit the specific needs of a fund, making them attractive for specialized hedging strategies such as currency risk management, despite potentially higher counterparty risk.
24. Which of the following types of risk is NOT mitigated by the use of derivatives for hedging purposes?
A. Interest rate risk
B. Credit risk
C. Currency risk
D. Market risk
Answer: B. Credit risk
Explanation: While derivatives are effective for managing market, currency, and interest rate risks, they do not mitigate credit risk, which is the risk of default by an issuer or counterparty.
25. A mutual fund manager writes a cash-secured put option with a strike price of $50 and receives a premium of $3. What is the manager’s effective purchase price if the option is exercised and the stock price falls to $40?
A. $50
B. $47
C. $40
D. $37
Answer: B. $47
Explanation: The manager’s effective purchase price is the strike price of $50 minus the $3 premium received, resulting in an effective purchase price of $47.
26. Which of the following is a key challenge in using derivatives for hedging fixed income portfolios?
A. Derivatives cannot hedge interest rate risk
B. Derivatives are too costly for fixed income portfolios
C. Derivatives may not adequately hedge credit spread risk
D. Derivatives increase a fund’s duration
Answer: C. Derivatives may not adequately hedge credit spread risk
Explanation: While derivatives can effectively hedge interest rate risk, they may not fully protect against credit spread risk, which can impact corporate bond holdings differently than government bonds.
27. Why might a fund manager choose to write covered call options during a period of low market volatility?
A. To reduce transaction costs
B. To limit downside risk
C. To generate additional income from option premiums
D. To increase market exposure
Answer: C. To generate additional income from option premiums
Explanation: Writing covered call options is a strategy used to generate additional income from option premiums, particularly in markets where the manager does not expect significant price movements.
28. In the context of mutual fund management, what is delta?
A. The time decay of an option’s value
B. The sensitivity of an option’s price to changes in the price of the underlying asset
C. The correlation between the fund’s NAV and its benchmark
D. The difference between the market price and the strike price of an option
Answer: B. The sensitivity of an option’s price to changes in the price of the underlying asset
Explanation: Delta measures how much an option’s price is expected to move for each one-point move in the price of the underlying asset. It is a key concept in options trading and risk management.
29. Which of the following strategies is most commonly used to hedge foreign currency risk in a Canadian mutual fund holding U.S. equities?
A. Buying U.S. dollar forward contracts
B. Selling Canadian dollar forward contracts
C. Selling U.S. dollar forward contracts
D. Buying Canadian dollar options
Answer: C. Selling U.S. dollar forward contracts
Explanation: To hedge currency risk from holding U.S. equities, a Canadian mutual fund would sell U.S. dollar forward contracts, thereby locking in an exchange rate and reducing exposure to U.S. dollar fluctuations.
30. Which of the following tax implications is associated with the use of derivatives in a mutual fund?
A. Income from derivatives is taxed as capital gains
B. Dividends earned through derivatives receive preferential tax treatment
C. Income from derivatives is generally taxed as ordinary income
D. There are no tax implications for derivatives in mutual funds
Answer: C. Income from derivatives is generally taxed as ordinary income
Explanation: Income from derivatives, such as gains from futures or options, is usually taxed as ordinary income rather than capital gains, which can result in higher tax liabilities for investors.
These questions cover various aspects of derivatives usage by mutual funds, including regulatory considerations, strategic applications, and the associated risks and benefits.
You said:
ChatGPT said:
Certainly! Here are 30 additional complex and challenging multiple-choice questions based on the content regarding the permitted uses of derivatives by mutual funds, complete with answers and detailed explanations:
1. A fund manager is using a short forward contract to hedge a foreign equity position. If the foreign currency appreciates, which of the following will occur?
A. The hedge will result in a gain, offsetting the currency appreciation
B. The hedge will result in a loss, reducing the benefit of the currency appreciation
C. The hedge will have no impact on the currency position
D. The hedge will create additional leverage in the fund
Answer: B. The hedge will result in a loss, reducing the benefit of the currency appreciation
Explanation: A short forward contract locks in a rate, and if the foreign currency appreciates, the forward contract will result in a loss. The hedge is designed to mitigate currency risk, so gains from currency appreciation are offset by losses on the forward contract.
2. Which of the following is a key requirement for a counterparty in an OTC derivatives contract under NI 81-102?
A. A minimum "AAA" credit rating
B. A minimum "A" credit rating
C. A minimum "BBB" credit rating
D. No minimum credit rating is required
Answer: B. A minimum "A" credit rating
Explanation: NI 81-102 mandates that counterparties in OTC derivatives contracts must have a minimum credit rating of "A" from DBRS Morningstar or an equivalent rating from other credit rating agencies. This helps manage counterparty risk.
3. Which of the following types of mutual funds is most likely to use derivatives to gain synthetic exposure to foreign markets?
A. Domestic bond funds
B. Domestic equity funds
C. International index funds
D. High-yield bond funds
Answer: C. International index funds
Explanation: International index funds frequently use derivatives like swaps and futures to gain synthetic exposure to foreign markets, which can be more cost-effective than purchasing all the underlying securities.
4. A mutual fund manager using a total return swap to replicate an index return will receive which of the following?
A. The dividends paid by the underlying assets
B. The interest on the underlying bonds
C. The total return of the index minus any financing costs
D. The total return of the index plus the cost of the swap
Answer: C. The total return of the index minus any financing costs
Explanation: In a total return swap, the fund manager receives the total return of the index, including price appreciation and dividends, minus any financing or transaction costs associated with the swap.
5. If a mutual fund manager sells a call option on an underlying asset without owning the asset, the manager is engaging in which strategy?
A. Writing a covered call
B. Writing a naked call
C. Writing a cash-secured put
D. Writing a covered put
Answer: B. Writing a naked call
Explanation: Selling a call option without owning the underlying asset is known as writing a naked call. This is riskier than a covered call because the manager may need to buy the asset at market price to deliver if the option is exercised.
6. Which of the following is NOT a potential benefit of using derivatives for hedging in mutual funds?
A. Mitigation of currency risk
B. Reduction of interest rate sensitivity
C. Increased market exposure
D. Protection against downside risk
Answer: C. Increased market exposure
Explanation: Hedging is primarily used to reduce risks such as currency fluctuations or interest rate sensitivity. Increasing market exposure is a strategy typically associated with non-hedging uses of derivatives.
7. Under NI 81-102, which of the following is allowed for a mutual fund to use for hedging purposes?
A. A derivative that increases the fund’s risk
B. A derivative that enhances the fund’s leverage
C. A derivative that has a high degree of negative correlation with the position being hedged
D. A derivative that provides speculative exposure to a new market
Answer: C. A derivative that has a high degree of negative correlation with the position being hedged
Explanation: For a derivative to qualify as a hedge under NI 81-102, it must have a high degree of negative correlation with the underlying position, meaning that it moves in the opposite direction, reducing the risk.
8. Which of the following scenarios best illustrates the use of a currency cross-hedge in a mutual fund?
A. Hedging U.S. dollar exposure with a U.S. dollar forward contract
B. Substituting exposure to the euro for exposure to the yen without increasing currency risk
C. Increasing the fund’s currency exposure by adding U.S. dollar derivatives
D. Selling U.S. dollar futures while holding Canadian equities
Answer: B. Substituting exposure to the euro for exposure to the yen without increasing currency risk
Explanation: A currency cross-hedge involves shifting exposure from one currency to another (such as euro to yen) without increasing the overall currency risk to the portfolio, as long as neither is the fund’s base currency.
9. In which situation would a mutual fund manager use a bond future to decrease the duration of the portfolio?
A. Buy long-term bond futures
B. Sell short-term bond futures
C. Sell long-term bond futures
D. Buy short-term bond futures
Answer: C. Sell long-term bond futures
Explanation: Selling long-term bond futures reduces the portfolio's duration, making it less sensitive to interest rate changes. This is a common strategy to decrease the interest rate risk in a fixed-income portfolio.
10. Which of the following best describes the risk of using derivatives to hedge against market volatility?
A. Market volatility may decrease, leading to larger derivative gains
B. Derivative hedges may not perfectly match the underlying positions
C. Hedging with derivatives eliminates market risk entirely
D. Derivative hedges increase the volatility of the underlying portfolio
Answer: B. Derivative hedges may not perfectly match the underlying positions
Explanation: A key risk in using derivatives for hedging is that the hedge may not perfectly offset the risk in the underlying position. This is often due to basis risk or imperfect correlation between the hedge and the position.
11. A mutual fund manager wants to protect the portfolio from rising interest rates. Which derivative strategy would be most appropriate?
A. Buy long-term bond futures
B. Sell short-term bond futures
C. Buy interest rate swaps with a floating rate leg
D. Sell interest rate swaps with a floating rate leg
Answer: D. Sell interest rate swaps with a floating rate leg
Explanation: Selling an interest rate swap with a floating rate leg allows the fund manager to receive fixed interest payments while paying a floating rate. If interest rates rise, the floating payments increase, but the fixed income received remains steady, providing protection.
12. Which of the following derivatives would a mutual fund manager likely use to hedge foreign equity exposure to currency risk?
A. Interest rate swap
B. Currency forward
C. Stock index future
D. Call option on interest rates
Answer: B. Currency forward
Explanation: A currency forward contract is the most appropriate instrument for hedging foreign equity exposure to currency risk. It locks in a future exchange rate, mitigating the impact of currency fluctuations.
13. Which of the following is true about the taxation of income generated by derivatives in mutual funds?
A. Income from derivatives is taxed as capital gains
B. Income from derivatives is taxed as ordinary income
C. Derivative income is tax-free in registered accounts
D. Derivatives generate no taxable income
Answer: B. Income from derivatives is taxed as ordinary income
Explanation: Income from derivatives is generally taxed as ordinary income rather than capital gains, which can result in higher tax liabilities for investors, depending on the type of account they hold.
14. Which of the following is the most likely disadvantage of using derivatives to manage currency risk in a mutual fund?
A. Currency derivatives can eliminate all market risks
B. Derivatives create exposure to credit risk from counterparties
C. Currency forwards automatically increase the fund’s leverage
D. Derivatives increase the fund’s tax liabilities in tax-advantaged accounts
Answer: B. Derivatives create exposure to credit risk from counterparties
Explanation: One of the key risks of using derivatives, particularly OTC derivatives like currency forwards, is credit risk from counterparties. If the counterparty defaults, the hedge may fail to provide the intended protection.
15. Which of the following strategies is most likely used to gain exposure to an entire equity market without buying individual securities?
A. Writing covered call options on individual stocks
B. Selling index futures
C. Buying index futures
D. Buying put options on individual securities
Answer: C. Buying index futures
Explanation: Buying index futures gives the fund exposure to an entire equity market, replicating the performance of an index without having to buy the individual securities that comprise the index.
16. Which of the following risks is mitigated when a mutual fund manager hedges a foreign bond position with a currency forward contract?
A. Market risk
B. Interest rate risk
C. Currency risk
D. Credit risk
Answer: C. Currency risk
Explanation: Currency risk is mitigated by using a currency forward contract, which locks in an exchange rate for the bond’s currency, protecting the fund from fluctuations in the foreign exchange market.
17. A mutual fund manager enters into a total return swap based on a foreign equity index. Which of the following best describes the return received by the manager?
A. The fund receives dividend payments from the index constituents
B. The fund receives the total return of the index minus any funding costs
C. The fund pays the total return of the index to the counterparty
D. The fund receives interest payments from the index constituents
Answer: B. The fund receives the total return of the index minus any funding costs
Explanation: In a total return swap, the fund receives the total return of the index, which includes both price changes and dividends, minus the costs of the swap agreement.
18. Which of the following best describes the purpose of writing a cash-secured put option?
A. To gain exposure to the underlying asset without paying the full price upfront
B. To speculate on the rise of the underlying asset’s price
C. To earn income from the premium while potentially acquiring the asset at a lower price
D. To protect against the decline in the price of the underlying asset
Answer: C. To earn income from the premium while potentially acquiring the asset at a lower price
Explanation: Writing a cash-secured put option allows the manager to earn income from the premium while potentially acquiring the asset at a lower price if the option is exercised.
19. Which of the following is a key difference between exchange-traded and OTC derivatives?
A. Exchange-traded derivatives are customized contracts
B. OTC derivatives are more liquid than exchange-traded derivatives
C. OTC derivatives involve higher counterparty risk than exchange-traded derivatives
D. Exchange-traded derivatives are not subject to regulatory oversight
Answer: C. OTC derivatives involve higher counterparty risk than exchange-traded derivatives
Explanation: OTC derivatives carry higher counterparty risk because they are traded directly between parties without the clearing and settlement guarantees provided by exchanges, which minimize such risks for exchange-traded derivatives.
20. If a fund manager writes a covered call option and the underlying asset price increases significantly, what is the primary risk?
A. The fund will be obligated to sell the underlying asset at a price below the current market value
B. The option will expire worthless, and the premium will be lost
C. The fund will be required to buy the asset at the current market price
D. The fund will experience unlimited losses if the price continues to rise
Answer: A. The fund will be obligated to sell the underlying asset at a price below the current market value
Explanation: The primary risk in writing a covered call is that if the underlying asset price rises significantly, the fund will have to sell the asset at the strike price, which may be below the current market value, thus missing out on potential gains.
21. Which of the following derivative strategies is used to increase portfolio exposure to a specific asset class without directly purchasing the assets?
A. Writing put options
B. Writing call options
C. Buying forward contracts
D. Selling futures contracts
Answer: C. Buying forward contracts
Explanation: Buying forward contracts allows a fund manager to gain exposure to a specific asset class, such as commodities or currencies, without having to directly purchase the underlying assets.
22. What is the primary objective of a mutual fund manager who writes covered call options on a portfolio of equities?
A. To protect against a decline in the portfolio’s value
B. To increase the portfolio’s leverage
C. To enhance portfolio income through option premiums
D. To speculate on a rise in the portfolio’s value
Answer: C. To enhance portfolio income through option premiums
Explanation: Writing covered call options is a strategy used to generate additional income from the option premiums. The manager is willing to sell the underlying equities at the strike price if the options are exercised.
23. Which of the following is most likely to be a disadvantage of using derivatives in a mutual fund for non-hedging purposes?
A. Increased transparency
B. Reduced market exposure
C. Higher transaction costs
D. Reduced tax efficiency
Answer: D. Reduced tax efficiency
Explanation: Derivatives used for non-hedging purposes may reduce tax efficiency since income from derivatives is typically taxed as ordinary income, which may not enjoy the preferential tax treatment of capital gains.
24. A mutual fund manager is using derivatives to increase the portfolio's duration. Which derivative strategy is the manager most likely employing?
A. Buying short-term bond futures
B. Selling long-term bond futures
C. Buying long-term bond futures
D. Selling short-term bond futures
Answer: C. Buying long-term bond futures
Explanation: Buying long-term bond futures increases the portfolio’s duration, making it more sensitive to interest rate changes. This is a strategy used when the manager expects interest rates to fall, leading to capital gains in the bond portfolio.
25. Which of the following is a potential risk of using interest rate swaps in a fixed-income mutual fund?
A. Reduced credit spread exposure
B. Higher counterparty risk in the case of OTC swaps
C. Increased leverage in the portfolio
D. Lower liquidity in exchange-traded instruments
Answer: B. Higher counterparty risk in the case of OTC swaps
Explanation: Interest rate swaps, particularly OTC swaps, expose the fund to counterparty risk. If the counterparty defaults, the fund may not receive the expected payments from the swap agreement.
26. Which of the following strategies is most appropriate for a fund manager who wants to hedge against a rise in short-term interest rates?
A. Buy long-term bond futures
B. Sell short-term interest rate futures
C. Buy long-term interest rate futures
D. Sell short-term bond futures
Answer: B. Sell short-term interest rate futures
Explanation: Selling short-term interest rate futures allows the fund to hedge against a rise in short-term rates, as the value of the futures contract would fall in response to rising rates, providing an offsetting gain to the fund.
27. A mutual fund manager using an interest rate swap to decrease the fund's duration would most likely:
A. Buy long-term interest rate swaps
B. Sell short-term interest rate swaps
C. Sell long-term interest rate swaps
D. Buy short-term interest rate swaps
Answer: C. Sell long-term interest rate swaps
Explanation: Selling long-term interest rate swaps reduces the fund's duration, decreasing its sensitivity to interest rate changes and making it less exposed to potential losses from rising interest rates.
28. What is a key advantage of using derivatives to replicate an index return in a mutual fund?
A. Reduced counterparty risk compared to owning the index
B. Reduced transaction costs compared to purchasing all underlying securities
C. Greater tax efficiency than directly holding index securities
D. Enhanced leverage for index returns
Answer: B. Reduced transaction costs compared to purchasing all underlying securities
Explanation: Using derivatives like futures or swaps to replicate an index return can significantly reduce transaction costs compared to buying all the individual securities in the index.
29. Which of the following scenarios best describes the risk of writing a cash-secured put option?
A. The price of the underlying asset increases above the strike price
B. The fund is required to sell the asset at a price below the market price
C. The fund is obligated to buy the underlying asset at the strike price if the option is exercised
D. The option expires worthless, resulting in no profit for the fund
Answer: C. The fund is obligated to buy the underlying asset at the strike price if the option is exercised
Explanation: Writing a cash-secured put option obligates the fund to buy the underlying asset at the strike price if the option is exercised, even if the market price is lower.
30. A mutual fund manager using options to generate additional income writes a put option on a stock. If the stock price falls significantly, what is the primary risk?
A. The stock will be called away from the fund
B. The option will expire worthless, and no income will be generated
C. The fund will be obligated to purchase the stock at the strike price
D. The fund will have to sell the stock at a lower market price
Answer: C. The fund will be obligated to purchase the stock at the strike price
Explanation: Writing a put option obligates the fund to purchase the stock at the strike price if the option is exercised, even if the stock price falls significantly below that level.
These questions cover additional advanced aspects of derivatives usage by mutual funds, offering a challenging exploration of regulatory frameworks, derivative strategies, and the associated risks.
You said:
ChatGPT said:
Here are another 30 complex and challenging multiple-choice questions based on the permitted uses of derivatives by mutual funds, with answers and explanations:
1. A mutual fund manager using interest rate swaps to hedge against rising rates would most likely:
A. Buy long-term fixed-rate swaps
B. Sell short-term fixed-rate swaps
C. Buy long-term floating-rate swaps
D. Sell long-term floating-rate swaps
Answer: D. Sell long-term floating-rate swaps
Explanation: Selling floating-rate swaps locks in fixed interest payments and protects against rising interest rates, which would otherwise increase the cost of floating-rate liabilities.
2. When using derivatives for non-hedging purposes, which of the following must a mutual fund hold to comply with NI 81-102?
A. A short position in the underlying asset
B. Sufficient cash or cash equivalents to cover potential obligations
C. A synthetic exposure to the underlying asset
D. A fixed percentage of the fund’s NAV in liquid assets
Answer: B. Sufficient cash or cash equivalents to cover potential obligations
Explanation: NI 81-102 requires that mutual funds hold cash or equivalent assets sufficient to cover potential obligations when using derivatives for non-hedging purposes to ensure that the fund can meet any liabilities arising from the derivative contracts.
3. In a situation where a mutual fund uses a currency forward contract to hedge foreign currency exposure, the fund is exposed to which additional risk?
A. Interest rate risk
B. Credit risk from the forward contract counterparty
C. Market risk from the foreign equity position
D. Inflation risk
Answer: B. Credit risk from the forward contract counterparty
Explanation: By entering into a forward contract, the mutual fund becomes exposed to credit risk from the counterparty. If the counterparty defaults, the hedge may fail, exposing the fund to currency fluctuations.
4. A mutual fund manager wants to increase the portfolio's exposure to foreign equities but minimize currency risk. Which of the following is the best approach?
A. Buy foreign equities directly and hedge currency risk using forwards
B. Buy U.S. equities without a hedge
C. Short domestic equities and buy foreign index futures
D. Use foreign equity derivatives and leave currency risk unhedged
Answer: A. Buy foreign equities directly and hedge currency risk using forwards
Explanation: Buying foreign equities and simultaneously using forwards to hedge currency risk allows the fund to gain exposure to foreign markets without assuming currency fluctuations.
5. Which of the following represents a key limitation for a mutual fund using derivatives for non-hedging purposes under NI 81-102?
A. The fund must hold 100% of its NAV in liquid assets
B. The fund cannot use derivatives to speculate
C. The fund cannot use derivatives to hedge risk
D. The fund must ensure it has no foreign exposure
Answer: B. The fund cannot use derivatives to speculate
Explanation: NI 81-102 imposes restrictions that prevent mutual funds from using derivatives to speculate. Derivatives for non-hedging purposes can be used for efficient portfolio management, but not for speculative gain.
6. Which of the following is most likely a risk when a mutual fund manager writes a naked call option?
A. The fund will lose the premium paid to the buyer
B. The fund will have to buy the underlying asset at market prices if exercised
C. The option will expire worthless
D. The fund will be required to sell the underlying asset at the strike price
Answer: B. The fund will have to buy the underlying asset at market prices if exercised
Explanation: Writing a naked call option (without owning the underlying asset) exposes the fund to the risk of having to purchase the asset at market price if the option is exercised and then sell it at the lower strike price, potentially causing significant losses.
7. A mutual fund is exposed to rising interest rates and the manager enters into an interest rate swap. Which position should the manager take in the swap to reduce the impact of rising rates?
A. Pay fixed, receive floating
B. Pay floating, receive fixed
C. Buy short-term Treasury futures
D. Sell long-term Treasury futures
Answer: B. Pay floating, receive fixed
Explanation: By paying floating and receiving fixed, the manager locks in fixed income and avoids the higher costs of rising interest rates, which would increase the payments on a floating-rate liability.
8. Which of the following is a key benefit of using options in a mutual fund portfolio for non-hedging purposes?
A. Reduction of market volatility
B. Enhanced portfolio liquidity
C. Opportunity to generate income from premiums
D. Full protection against market downturns
Answer: C. Opportunity to generate income from premiums
Explanation: Writing options (both covered calls and cash-secured puts) can provide a mutual fund with additional income in the form of option premiums, which can enhance returns in flat or modestly rising markets.
9. When a fund manager uses currency cross-hedging, which of the following outcomes is most likely?
A. The fund eliminates all foreign currency risk
B. The fund’s NAV is exposed to increased market risk
C. The fund substitutes one currency risk for another without increasing total currency exposure
D. The fund’s leverage ratio increases substantially
Answer: C. The fund substitutes one currency risk for another without increasing total currency exposure
Explanation: In currency cross-hedging, the manager replaces exposure to one foreign currency with another without increasing the total amount of currency risk. This can be useful if the manager believes the substitute currency will perform better relative to the base currency.
10. If a mutual fund manager writes a cash-secured put option on a stock, what is the primary risk if the stock price falls below the strike price?
A. The stock will be called away at a lower price
B. The fund will have to sell the stock at a loss
C. The fund will have to purchase the stock at the strike price, which may be above market price
D. The fund will have to pay the option premium
Answer: C. The fund will have to purchase the stock at the strike price, which may be above market price
Explanation: Writing a cash-secured put obligates the fund to purchase the stock at the strike price if the option is exercised. If the stock price falls significantly, the fund may end up buying the stock at a price higher than the market value.
11. Which of the following is true regarding the use of futures contracts to manage interest rate risk in a mutual fund?
A. Buying futures increases the fund’s exposure to interest rate movements
B. Selling futures increases the fund’s duration
C. Selling futures increases the fund’s sensitivity to interest rate decreases
D. Buying futures reduces the fund’s duration
Answer: A. Buying futures increases the fund’s exposure to interest rate movements
Explanation: Buying futures increases the fund’s exposure to interest rate changes by effectively increasing its duration. This can be beneficial if the manager expects rates to fall, as bond prices would rise.
12. A mutual fund manager is concerned about a potential decline in U.S. dollar exposure. Which of the following derivative strategies is most appropriate for managing this risk?
A. Buy a U.S. dollar forward contract
B. Sell a U.S. dollar forward contract
C. Buy a Canadian dollar forward contract
D. Sell a Canadian dollar forward contract
Answer: B. Sell a U.S. dollar forward contract
Explanation: Selling a U.S. dollar forward contract locks in a future price to exchange U.S. dollars for Canadian dollars, which helps the fund mitigate the risk of a decline in the U.S. dollar's value against the Canadian dollar.
13. Which of the following is NOT a regulatory requirement under NI 81-102 for the use of derivatives in a mutual fund?
A. The fund must hold enough liquid assets to cover potential obligations
B. The fund must limit its exposure to an individual OTC derivatives counterparty to 10% of NAV
C. The fund must disclose its use of derivatives in the prospectus
D. The fund must limit its derivatives exposure to no more than 20% of NAV
Answer: D. The fund must limit its derivatives exposure to no more than 20% of NAV
Explanation: NI 81-102 does not impose a strict limit of 20% of NAV on derivatives exposure. However, it does impose other requirements, such as sufficient liquid assets to cover obligations, disclosure requirements, and counterparty exposure limits.
14. Which of the following is an advantage of using OTC derivatives for a mutual fund manager over exchange-traded derivatives?
A. Lower counterparty risk
B. Greater transparency
C. Customization of contract terms
D. Higher liquidity
Answer: C. Customization of contract terms
Explanation: OTC derivatives offer customization, allowing managers to tailor the terms of the contract to meet specific needs. However, they come with higher counterparty risk and lower transparency compared to exchange-traded derivatives.
15. A mutual fund manager writes a covered call option. What is the primary risk if the stock price rises significantly?
A. The option will expire worthless
B. The manager will have to sell the stock at the strike price, losing potential gains
C. The manager will have to buy the stock at the market price
D. The manager will be forced to buy back the call option at a higher price
Answer: B. The manager will have to sell the stock at the strike price, losing potential gains
Explanation: When writing a covered call, if the stock price rises significantly, the manager is obligated to sell the stock at the strike price, which may result in the loss of potential upside gains beyond the strike price.
16. Which of the following strategies would a fund manager most likely use to increase the duration of a fixed-income portfolio?
A. Buy long-term bond futures
B. Sell short-term bond futures
C. Buy short-term bond futures
D. Sell long-term bond futures
Answer: A. Buy long-term bond futures
Explanation: Buying long-term bond futures increases the duration of the portfolio, making it more sensitive to interest rate changes. This strategy is typically used when a manager expects interest rates to fall.
17. Which of the following derivative strategies would best hedge against a decrease in the value of a foreign currency held in a mutual fund?
A. Sell a currency forward contract
B. Buy a currency forward contract
C. Write a covered call on the foreign currency
D. Write a cash-secured put on the foreign currency
Answer: A. Sell a currency forward contract
Explanation: Selling a currency forward locks in the future exchange rate and protects the fund from a decrease in the value of the foreign currency relative to the domestic currency.
18. Which of the following strategies exposes a mutual fund to unlimited risk?
A. Writing a naked call option
B. Writing a covered call option
C. Buying a put option
D. Writing a cash-secured put option
Answer: A. Writing a naked call option
Explanation: Writing a naked call option (where the writer does not own the underlying asset) exposes the fund to unlimited risk if the price of the underlying asset rises substantially, as the fund may be forced to buy the asset at an increasingly higher price.
19. What is the primary benefit of using interest rate swaps to hedge the duration of a bond portfolio?
A. Increased portfolio liquidity
B. Complete elimination of interest rate risk
C. Ability to fine-tune the portfolio's interest rate sensitivity
D. Reduced transaction costs
Answer: C. Ability to fine-tune the portfolio's interest rate sensitivity
Explanation: Interest rate swaps allow a manager to adjust the portfolio’s duration and interest rate sensitivity without buying or selling physical bonds, providing flexibility in managing interest rate risk.
20. Which of the following is a potential disadvantage of using derivatives for hedging purposes in a mutual fund?
A. Increased portfolio volatility
B. Higher transaction costs compared to traditional securities
C. Basis risk, where the hedge does not perfectly offset the underlying exposure
D. Complete elimination of market risk
Answer: C. Basis risk, where the hedge does not perfectly offset the underlying exposure
Explanation: Basis risk occurs when the derivative used for hedging does not perfectly correlate with the underlying exposure, leading to imperfect risk mitigation. This is a common challenge in hedging strategies.
21. Which of the following is a key difference between using options and futures in a mutual fund portfolio?
A. Options provide leverage, while futures do not
B. Options require an upfront premium, while futures do not
C. Futures contracts expire, while options do not
D. Futures are used for hedging, while options are only used for speculation
Answer: B. Options require an upfront premium, while futures do not
Explanation: Options require the payment of a premium upfront to obtain the rights of the contract, whereas futures do not have an upfront premium but involve a margin requirement.
22. A fund manager decides to hedge foreign bond exposure by entering into a cross-currency swap. What does the fund receive under the swap?
A. Foreign interest payments in the domestic currency
B. Fixed interest payments in the foreign currency
C. Floating interest payments in the domestic currency
D. Principal and interest payments in the foreign currency
Answer: A. Foreign interest payments in the domestic currency
Explanation: In a cross-currency swap, the fund receives interest payments in its domestic currency while paying interest in the foreign currency. This helps mitigate foreign exchange risk while maintaining exposure to foreign interest rates.
23. Which of the following factors would most likely lead a mutual fund manager to use a total return swap instead of purchasing the underlying assets?
A. The assets are difficult or costly to acquire directly
B. The manager wants to reduce the fund’s credit risk
C. The manager wants to eliminate market risk
D. The assets are very liquid and readily available
Answer: A. The assets are difficult or costly to acquire directly
Explanation: A total return swap allows the fund to gain exposure to an asset without purchasing it directly, which can be beneficial when the underlying assets are difficult or costly to acquire.
24. Which of the following is a key advantage of using exchange-traded derivatives over OTC derivatives in a mutual fund?
A. Lower liquidity
B. Greater customization
C. Lower counterparty risk
D. Higher margin requirements
Answer: C. Lower counterparty risk
Explanation: Exchange-traded derivatives typically have lower counterparty risk because the clearinghouse guarantees the performance of the contracts, unlike OTC derivatives where the risk is directly with the counterparty.
25. Which of the following best describes the role of margin in a futures contract for a mutual fund?
A. Margin reduces the fund’s exposure to market fluctuations
B. Margin represents the full cost of entering a futures contract
C. Margin is a performance bond ensuring that both parties meet their obligations
D. Margin is the premium paid upfront to enter the futures contract
Answer: C. Margin is a performance bond ensuring that both parties meet their obligations
Explanation: Margin in futures contracts acts as a performance bond, ensuring that both parties fulfill their contractual obligations. It is not the full cost of the contract but a small percentage of the contract’s notional value.
26. Which of the following is a potential advantage of using derivatives to increase market exposure in a mutual fund?
A. Reduced regulatory oversight
B. Ability to gain exposure with limited capital
C. Complete elimination of counterparty risk
D. Lower transaction costs compared to traditional asset purchases
Answer: B. Ability to gain exposure with limited capital
Explanation: Derivatives allow a fund to gain significant exposure with limited initial capital outlay due to the leverage they provide. However, this comes with increased risk.
27. What is a key risk for a mutual fund manager who buys an out-of-the-money put option as a hedge?
A. The option will be exercised early, causing losses
B. The underlying asset will increase in value
C. The option may expire worthless if the underlying asset’s price doesn’t fall enough
D. The fund will be required to sell the asset at a loss
Answer: C. The option may expire worthless if the underlying asset’s price doesn’t fall enough
Explanation: If the underlying asset's price does not fall below the strike price of the out-of-the-money put option, the option will expire worthless, and the fund will lose the premium paid for the hedge.
28. A mutual fund manager uses bond futures to manage portfolio duration. What is the primary risk if interest rates rise unexpectedly?
A. The futures will increase in value, leading to gains
B. The futures will decline in value, resulting in losses
C. The duration of the portfolio will decrease
D. The futures will provide full protection against interest rate increases
Answer: B. The futures will decline in value, resulting in losses
Explanation: If interest rates rise, bond futures will decline in value, resulting in losses for the fund, particularly if the manager was using futures to increase the portfolio's duration.
29. Which of the following is a risk unique to using total return swaps in a mutual fund portfolio?
A. Basis risk
B. Counterparty risk
C. Currency risk
D. Interest rate risk
Answer: B. Counterparty risk
Explanation: Total return swaps are OTC derivatives, and they expose the fund to counterparty risk because the fund depends on the counterparty to meet its obligations under the swap agreement.
30. Which of the following best describes the impact of buying a call option on a stock in a mutual fund portfolio?
A. The fund limits potential gains to the strike price
B. The fund gains leveraged exposure to the stock with limited downside risk
C. The fund increases its exposure to interest rate risk
D. The fund is obligated to purchase the stock at the strike price
Answer: B. The fund gains leveraged exposure to the stock with limited downside risk
Explanation: Buying a call option provides leveraged exposure to the stock’s potential upside while limiting downside risk to the premium paid for the option.
These questions aim to cover more complex aspects of derivatives usage, strategies, and associated risks in the context of mutual funds.
You said:
ChatGPT said:
Here are 30 additional complex and challenging multiple-choice questions, complete with answers and explanations, based on the permitted uses of derivatives by mutual funds:
1. A mutual fund manager enters into a swap to gain exposure to the S&P 500 Index. Which of the following is the most likely cash flow in the swap contract?
A. The fund receives the total return of the S&P 500 and pays a floating interest rate
B. The fund pays the total return of the S&P 500 and receives the return on cash
C. The fund receives the total return of the S&P 500 and pays the index’s dividend yield
D. The fund pays the total return of the S&P 500 and receives fixed interest payments
Answer: A. The fund receives the total return of the S&P 500 and pays a floating interest rate
Explanation: In total return swaps, the fund typically receives the total return of the underlying asset (e.g., the S&P 500) and pays an interest rate, often a floating rate, in return. This allows the fund to gain exposure to the index without owning the underlying securities.
2. Which of the following is an advantage of using index futures for portfolio rebalancing in a mutual fund?
A. Index futures minimize tracking error relative to the benchmark
B. Index futures eliminate the need to hold cash reserves
C. Index futures allow the fund to avoid transaction costs related to buying individual securities
D. Index futures reduce counterparty risk
Answer: C. Index futures allow the fund to avoid transaction costs related to buying individual securities
Explanation: Index futures enable a mutual fund to adjust exposure to an index without buying or selling individual securities, thus reducing transaction costs and execution slippage.
3. A mutual fund manager uses a short position in interest rate futures to hedge a portfolio of long bonds. If interest rates rise, what is the likely outcome for the fund?
A. The value of the futures position will increase, offsetting bond price declines
B. The value of both the futures and bond positions will decrease
C. The futures position will lose value, but the bonds will increase in price
D. The fund will realize gains in both the futures and bond positions
Answer: A. The value of the futures position will increase, offsetting bond price declines
Explanation: When interest rates rise, bond prices fall, but a short position in interest rate futures will increase in value, offsetting some or all of the losses in the bond portfolio.
4. Which of the following is a limitation when using derivatives for non-hedging purposes under NI 81-102?
A. Derivatives cannot be used to alter a fund’s asset allocation
B. The fund must hold sufficient cash or equivalents to meet potential derivative obligations
C. Derivatives cannot be used to generate income
D. The fund must disclose derivative use only when exceeding 10% of NAV
Answer: B. The fund must hold sufficient cash or equivalents to meet potential derivative obligations
Explanation: Under NI 81-102, mutual funds using derivatives for non-hedging purposes must hold sufficient cash or cash equivalents to meet any potential obligations arising from the derivative contracts.
5. In a scenario where a mutual fund manager sells put options on a stock index, which of the following represents the most significant risk?
A. The underlying index rises sharply
B. The underlying index falls sharply
C. The underlying index remains flat
D. The options expire in-the-money
Answer: B. The underlying index falls sharply
Explanation: Selling put options exposes the fund to potential losses if the underlying index declines sharply, as the manager may be forced to buy the index at a higher strike price than the current market value.
6. Which of the following risks is mitigated when a mutual fund manager hedges a portfolio of U.S. stocks with currency futures?
A. Market risk
B. Liquidity risk
C. Interest rate risk
D. Currency risk
Answer: D. Currency risk
Explanation: By using currency futures, the manager hedges against fluctuations in exchange rates, thereby mitigating currency risk for the portfolio’s U.S. dollar-denominated holdings.
7. A mutual fund is exposed to a decline in interest rates. Which of the following strategies would most likely protect the fund from falling interest rates?
A. Selling interest rate futures
B. Buying short-term Treasury bonds
C. Buying long-term bond futures
D. Writing call options on long-term bonds
Answer: C. Buying long-term bond futures
Explanation: When interest rates decline, long-term bond prices increase. Buying long-term bond futures allows the fund to benefit from falling interest rates by gaining exposure to bonds that will appreciate in value.
8. Which of the following derivative strategies would allow a mutual fund to increase portfolio income while maintaining existing stock positions?
A. Selling covered call options
B. Buying put options
C. Selling naked call options
D. Selling forward contracts on stocks
Answer: A. Selling covered call options
Explanation: Selling covered calls generates income from option premiums while allowing the fund to maintain its current stock positions. The trade-off is the potential loss of upside if the stock rises above the strike price.
9. A fund manager uses an interest rate swap to hedge against rising interest rates. In this swap, the fund pays floating and receives fixed. If interest rates increase, how does the swap impact the fund?
A. The fund’s floating payments increase, but it receives the same fixed payments
B. The fund receives higher floating payments and pays lower fixed payments
C. The fund’s fixed payments increase, reducing its protection against rising rates
D. The fund’s fixed payments decrease, resulting in losses on the swap
Answer: A. The fund’s floating payments increase, but it receives the same fixed payments
Explanation: In a pay-floating, receive-fixed swap, the fund’s floating rate payments increase when interest rates rise, but the fund continues to receive the same fixed payments, providing protection against rising interest rates.
10. Which of the following outcomes best represents the use of writing cash-secured put options in a mutual fund?
A. The fund is obligated to sell shares if the option is exercised
B. The fund earns premiums and is obligated to buy shares if the option is exercised
C. The fund earns dividends from the underlying shares
D. The fund increases leverage without adding cash reserves
Answer: B. The fund earns premiums and is obligated to buy shares if the option is exercised
Explanation: Writing cash-secured put options generates income from premiums. If the option is exercised, the fund must purchase the underlying shares at the strike price, which is why the fund needs to hold enough cash to cover the purchase.
11. Which of the following strategies would a mutual fund manager most likely use to gain exposure to an equity market without purchasing the underlying securities?
A. Buying stock index futures
B. Writing cash-secured put options on individual stocks
C. Selling covered call options on individual stocks
D. Buying foreign currency futures
Answer: A. Buying stock index futures
Explanation: Stock index futures provide exposure to the entire equity market without the need to purchase each individual security in the index, making it a cost-effective method for gaining market exposure.
12. A fund manager hedges a bond portfolio using interest rate swaps. If interest rates fall unexpectedly, what is the primary risk to the fund?
A. The floating rate payments on the swap increase
B. The fixed payments received on the swap decline
C. The market value of the bonds in the portfolio decreases
D. The fund misses out on gains from declining interest rates
Answer: D. The fund misses out on gains from declining interest rates
Explanation: When interest rates fall, bond prices rise. If the manager hedged the portfolio with interest rate swaps, the hedge might prevent the fund from fully benefiting from the gains that would occur due to declining rates.
13. In what situation would a mutual fund manager use a currency swap instead of a forward contract?
A. When the manager needs to hedge short-term currency exposure
B. When the manager seeks to exchange fixed for floating interest payments
C. When the manager needs to hedge long-term currency exposure and interest rate differentials
D. When the manager wants to speculate on short-term currency fluctuations
Answer: C. When the manager needs to hedge long-term currency exposure and interest rate differentials
Explanation: A currency swap is typically used for long-term hedging, as it allows the exchange of both principal and interest payments between two currencies, which can account for interest rate differentials over a longer horizon.
14. Which of the following risks is unique to using a total return swap to replicate an index in a mutual fund portfolio?
A. Currency risk
B. Counterparty risk
C. Market risk
D. Liquidity risk
Answer: B. Counterparty risk
Explanation: Total return swaps are typically OTC contracts, meaning the fund is exposed to the risk that the counterparty may default on its obligations, making counterparty risk a key consideration.
15. A mutual fund manager buys a call option on a stock index as a hedge. Which of the following best describes the purpose of this strategy?
A. To protect against a decline in the stock index
B. To generate income from option premiums
C. To benefit from a potential increase in the stock index
D. To gain exposure to interest rate movements
Answer: C. To benefit from a potential increase in the stock index
Explanation: Buying a call option on a stock index allows the manager to benefit from a potential rise in the index while limiting downside risk to the premium paid for the option.
16. Which of the following describes a primary risk when using derivatives for portfolio hedging?
A. Derivatives increase the portfolio's leverage
B. Derivatives eliminate interest rate risk
C. Basis risk occurs when the derivative’s price moves differently from the underlying position
D. Derivatives provide full protection against downside risk
Answer: C. Basis risk occurs when the derivative’s price moves differently from the underlying position
Explanation: Basis risk arises when the price of the derivative used for hedging does not perfectly match the price movement of the underlying position, leading to imperfect protection.
17. A mutual fund manager uses bond futures to decrease the duration of the portfolio. What is the most likely impact if interest rates rise?
A. The futures position will lose value, increasing the portfolio’s sensitivity to interest rates
B. The futures position will gain value, offsetting bond price declines
C. The bond portfolio will gain value as rates rise
D. The portfolio’s duration will increase, making it more sensitive to rate changes
Answer: B. The futures position will gain value, offsetting bond price declines
Explanation: Selling bond futures reduces portfolio duration. When interest rates rise, bond prices fall, but the short futures position gains value, offsetting the decline in the bond portfolio.
18. Which of the following best describes the potential disadvantage of writing covered call options in a rising market?
A. The fund retains full upside potential but risks losses
B. The fund is obligated to buy the underlying stock at the strike price
C. The fund must pay the option premium upfront
D. The fund must sell the underlying stock at the strike price, limiting potential gains
Answer: D. The fund must sell the underlying stock at the strike price, limiting potential gains
Explanation: When writing covered calls, if the stock price rises above the strike price, the fund is obligated to sell the stock at the strike price, thereby capping potential gains above that level.
19. Which of the following strategies is most appropriate for a mutual fund manager who wants to protect against a decline in the value of a foreign currency-denominated bond portfolio?
A. Selling currency futures
B. Buying currency futures
C. Selling bond futures
D. Writing put options on foreign bonds
Answer: A. Selling currency futures
Explanation: Selling currency futures locks in an exchange rate for the foreign currency, protecting the fund from potential declines in the value of the currency relative to the domestic currency.
20. Which of the following is a key benefit of using forward contracts instead of futures for hedging currency risk in a mutual fund?
A. Higher liquidity and lower transaction costs
B. No counterparty risk
C. Greater customization of contract terms
D. Access to standardized exchange contracts
Answer: C. Greater customization of contract terms
Explanation: Forward contracts are OTC derivatives, which allow for greater customization of terms such as settlement dates and contract size, making them more flexible for specific hedging needs compared to exchange-traded futures.
21. If a mutual fund manager writes a naked call option, what is the maximum potential loss?
A. The premium received
B. The difference between the strike price and the premium received
C. The difference between the strike price and the market price of the asset
D. Unlimited
Answer: D. Unlimited
Explanation: Writing a naked call option exposes the fund to unlimited risk if the price of the underlying asset rises significantly, as the fund may have to buy the asset at a much higher price to fulfill the option.
22. A fund manager is concerned about a potential increase in inflation. Which of the following derivative strategies would help protect the fund from rising inflation?
A. Buying bond futures
B. Buying interest rate swaps with a floating rate leg
C. Selling inflation swaps
D. Buying inflation swaps
Answer: D. Buying inflation swaps
Explanation: Buying inflation swaps allows the fund to receive payments tied to inflation rates, providing protection against rising inflation.
23. Which of the following is a potential risk when using OTC derivatives in a mutual fund portfolio?
A. Counterparty default risk
B. Increased liquidity
C. Standardized contract terms
D. Elimination of interest rate risk
Answer: A. Counterparty default risk
Explanation: OTC derivatives are traded directly between counterparties, which exposes the fund to the risk that the counterparty may default on its obligations, unlike exchange-traded derivatives, which are backed by clearinghouses.
24. In the context of hedging with derivatives, which of the following best defines delta?
A. The amount of time remaining until the derivative expires
B. The sensitivity of an option’s price to changes in the price of the underlying asset
C. The rate of change in the price of the underlying asset
D. The volatility of the underlying asset
Answer: B. The sensitivity of an option’s price to changes in the price of the underlying asset
Explanation: Delta measures how much the price of an option is expected to change for each 1-point movement in the price of the underlying asset. It is an important metric in option pricing and risk management.
25. Which of the following is the most appropriate strategy for a mutual fund manager looking to hedge against rising interest rates?
A. Buying long-term bond futures
B. Selling long-term bond futures
C. Writing put options on long-term bonds
D. Buying long-term Treasury bonds
Answer: B. Selling long-term bond futures
Explanation: Selling long-term bond futures allows the fund to hedge against rising interest rates, which would cause bond prices to fall. The short position in futures would gain in value as rates rise.
26. Which of the following would allow a mutual fund manager to reduce the portfolio’s sensitivity to interest rate changes?
A. Buying long-term interest rate futures
B. Selling short-term interest rate swaps
C. Buying long-term interest rate swaps
D. Selling long-term bond futures
Answer: D. Selling long-term bond futures
Explanation: Selling long-term bond futures reduces the portfolio’s duration, which decreases its sensitivity to changes in interest rates.
27. Which of the following risks does a mutual fund face when using interest rate swaps to hedge a bond portfolio?
A. Currency risk
B. Market risk
C. Credit risk from the counterparty
D. Liquidity risk
Answer: C. Credit risk from the counterparty
Explanation: Interest rate swaps are often OTC contracts, which expose the fund to credit risk if the counterparty fails to fulfill its obligations under the swap agreement.
28. A mutual fund manager buys a put option on a stock index. If the index declines, what will be the impact on the put option?
A. The value of the put option will increase
B. The value of the put option will decrease
C. The put option will expire worthless
D. The fund will be obligated to buy the index at the strike price
Answer: A. The value of the put option will increase
Explanation: When the price of the underlying index declines, the value of the put option increases, as it gives the holder the right to sell the index at a higher strike price.
29. Which of the following is a key advantage of using index futures for exposure to a market?
A. Index futures are not subject to margin requirements
B. Index futures have lower counterparty risk than ETFs
C. Index futures allow for quick and cost-effective adjustments to market exposure
D. Index futures provide superior tax treatment compared to owning the underlying index
Answer: C. Index futures allow for quick and cost-effective adjustments to market exposure
Explanation: Index futures provide a cost-effective and efficient way to adjust a portfolio’s market exposure without needing to buy or sell individual securities.
30. Which of the following strategies would most likely expose a mutual fund to significant counterparty risk?
A. Buying exchange-traded options
B. Buying OTC currency swaps
C. Selling exchange-traded futures
D. Buying Treasury bonds
Answer: B. Buying OTC currency swaps
Explanation: OTC currency swaps are customized, privately traded contracts that carry significant counterparty risk because they are not guaranteed by a clearinghouse, unlike exchange-traded derivatives.
Comments
Post a Comment